Since 2010 global markets have witnessed a flight to yield and quality. In Australia this has been more a flight from resources, but the result is the strong performance of financials, utilities and staples. Investors are looking to invest in companies that are of high quality, are stable, and have steady cash flows. They are looking for stocks that pay regular dividends, and particularly in low interest rate environments, even begin to look like bonds. But successful quality investing means looking at many different factors, and quality investing is definitely not new.
Value investing, on the other hand, is about buying stocks cheaply. An investor may select a group of stocks based on valuation metrics such as high dividend yield or low price-earnings ratio. These metrics will tell you if a stock is cheap but tell you nothing about how healthy the company is. For example, a stock that is in financial difficulty is cheap for a very good reason. This is when quality measures are useful. Quality looks at the health of a firm based on information in the financial statements thus allowing an investor to avoid poor quality firms that are cheap, also known as ‘value traps’.
How is quality measured?
Quality investing extends back to the work of Benjamin Graham in his 1949 book The Intelligent Investor. Whilst Graham is considered the father of value investing the book also indicates he is also the founder of quality investing with the important claim that the greatest losses in share prices come not from buying quality at an excessively high price but, rather, from buying low quality at a price that seems like good value.
Quality measures gained popularity after the burst of the dot com bubble and the spectacular failures of companies such as Enron and WorldCom. More recently the global financial crisis and subsequent sovereign credit crisis has resulted in a resurgent interest in quality measures.
But how do we measure quality? There is no one specific measure, but most of these methods look to identify companies that have high predictability of earnings and if possible earnings growth. Some investors start with companies with strong branding, good governance, and well-defined customer base. Others look for staple products, large distribution, and input costs that are easily controlled and modelled.
One of the most popular measures is Piotroski’s F-score developed by Joseph Piotroski and published in his 2000 paper, “The use of financial statement information to separate winners from losers”. Starting with a portfolio of value stocks, Piotroski looked at whether it was possible to improve performance by eliminating those of the lowest quality. He did this by scoring a stock on nine metrics. For each metric that is met a stock is scored one point as a sign of strength, but if it is not met then zero is assigned as a sign of weakness. The scores are then aggregated to a score out of nine for each stock. The higher the score, the better quality the company.
The nine individual measures of the Piotroski F-score are:
- Positive return on assets (ROA) in the current year
- Positive operating cash flow (OCF) in the current year
- Higher return on assets in the current year than the return on assets in the previous year (ROAX)
- Cash flow from operations greater than net income (ACCRUAL)
- Lower ratio of long term debt to assets in the current year compared to the previous year (LEVERAGE)
- Higher current ratio this year compared to the previous year (LIQUIDITY)
- No new shares were issued in the last year (EQUITY)
- A higher gross margin compared to the previous year (MARGIN)
- A higher asset turnover ratio compared to the previous year (TURNOVER)
Each of these measures captures different aspects of a firm’s health.
The first three measures capture profitability or whether the firm can generate funds through operating activities.
The accrual measure is an earnings manipulation factor and is widely known in earnings quality research. Accruals are measured as the difference between profits and cash flow from operations. If a company is reporting positive accruals, its management could be manipulating earnings by ‘borrowing’ earnings from future cash flow.
Three of the signals measure changes in capital structure. Leverage looks at the firms long-term debt levels. A company that increases its long term debt perhaps cannot generate sufficient internal funds from its business. Similarly companies that raise external capital by issuing new shares could be signalling their inability to generate sufficient internal funds. Change in current assets to current liabilities is known as liquidity. A company which has improving liquidity is a good indicator about its ability to pay its debt obligations.
The remaining two signals are designed to measure changes in the efficiency of the firms operations. An improvement in margins could mean an improvement in managing costs and/or a rise in the price of the firm’s product. An improvement in asset turnover signifies greater productivity from the assets. This can come either from more efficient operations or an increase in sales.
Strengths and weaknesses of the measures
Individually, the nine measures have at times been labelled as weak and having limitations. But together they are a broad brush that can be applied to an index or a large portfolio, and successfully identify companies that are having financial difficulty. Most companies will score in the range five to seven, and they are likely to be safe. But a company that is only scoring one or two out of a possible nine really needs to be looked at very closely.
In the Australian market stocks with low f-scores (scores three or less) tend to demonstrate falling earnings, a reduction in dividends, lower share price performance and increased share price volatility. Companies scoring eight or nine tend to have the opposite characteristics, and portfolios made from high quality value stocks have outperformed over the long term.
Quality measures work best in down markets when investors are looking for certainty. It performs best during a recession (e.g. the tech wreck in the early 2000’s and the GFC). It tends to only perform poorly during speculative periods of ‘irrational exuberance’ such as the dotcom bubble (late 1990’s-2000) and the resources boom of 2004 to 2007. During these environments risk appetite increases and investors are willing to speculate on low quality companies. In the sideways market of 2010-2012, following the strong rebound in 2009, market and thematic certainty disappeared and investors moved towards stock level earnings certainty.
In conclusion whilst there is no single measure to define what a quality company is, there are a number of combined metrics which can indicate the overall financial health of a company and provide indications of quality. These measures can certainly help to provide some downside protection especially in more benign or tough market conditions.
Raelene De Souza is a Portfolio Manager at Realindex Investments.